Italy's Letta Presses Ahead

Fresh from a victory over Berlusconi, Italian Prime Minister Letta is pressing ahead with a modest reform program that also tilts away from the path of his technocrat predecessor, without apparently abandoning fiscal discipline. In time to meet the EC deadline, the Italian cabinet approved the 2014 budget yesterday. It must now pass the Italian parliament after a final debate. There are two notable aspects of the budget. First, the government is offering a three-year strategy. This is helpful to businesses and investors. Second, the Letta government is shifting the focus from the tax hikes that Monti emphasized to spending cuts. The government projects a 2.5% deficit next year. It is below the EC target of 3% and would allow scope for a little slippage, if the economy is weaker than anticipated or if there was some other disruption. The budget cuts spending 2.5 bln euros for the central government and will force regional governments to cut spending by 1 bln euros. Moreover, the new budget will begins the 3-year 5 bln euro reduction labor tax reduction and a 5.6 bln corporate tax cut and stems from a cut in the payroll tax. The budget also calls for the sale of some 500 mln euros of government owned real estate. This will allow a reduction in what is called the "tax wedge" and is central to Letta's efforts to revitalize the economy. The "tax wedge" refers to the difference between the cost incurred by a business to hire workers and the net compensation the employees receive. Italy's fiscal problem is not and has not really been the annual deficit for several years. The fiscal problem is the accumulation of past deficit (debt) that now amounts to around 130% of GDP. The fiscal problem is exacerbated by slow growth. The current downturn is already seven quarters long and Q3 was likely the eighth. That was preceded by a seven quarter expansion in 2010 and the first three quarters of 2011. In turn, that expansion was preceded by a seven quarter contraction beginning in Q2. Letta would likely argue that lowering the payroll tax, and the "tax wedge" creates incentives (or reduces disincentives) for hiring and that this will boost the Italian economy and make it more competitive. Surely there is some merit in such arguments. On the other hand, there remains rigidities in the political economy that fosters rent seeking behavior be economic agents, including the bureaucracy. Signs of greater political stability following Berlusconi's recent climb down has been greeted warmly by investors. Italian bonds have outperformed Spanish bonds and the benchmark 10-year rate in Italy is back below Spain's. Italian stocks are doing well, though with an 8% gain over the past month are lagging slightly behind Spain's (9.3% increase), though still leading most of the other developed markets. The next test for the Letta government may be the Senate vote to expel Berlusconi, but that dies already appears cast. The ECB's asset quality review (AQR) which is expected to be outlined next week, may be the next financial challenge.